While listening to my regular dose of Kahnemann, I thought up an interesting metaphor to describe irrationality (this is original, you heard it here first). In lay language, we tend to define Rationality vs Irrationality as opposites, akin to Black vs White. Kahnemann describes it differently, as IMPERFECT rationality, not Irrationality.
Declaimer: This article was originally in October 2016, and some of the data points may be outdated
Think of Rationality as cheese, or a sponge, which is full of holes. When you look at them, how much is cheese/sponge, and how much is air? So should you say, “This is a sponge” when more than half of it is air?!
The Objective of Behavioural Economics
So pure Rationality is this intangible, evanescent concept, which is in reality riddled with holes like a sponge or a Swiss cheese. The objective of Behavioural Economics is to shore up this Rationality, somewhat like if we were to fill up the (holes in the) Swiss cheese with more Swiss cheese. But the Swiss cheese going into the hole itself has some air (smaller holes). So have we increased more substance with that exercise? Maybe yes, but the filled-up Swiss cheese remains as full of holes as ever.
It’s an interesting concept. There is no such thing as perfect Rationality, which the neophyte believes is the promise held out to him, as he looks down at the vista that is now called Behavioural Economics. But a consciousness of Irrationality is like religion in your everyday life. It provides principles and rules, which are useful in conducting your everyday life, very much like the vegetarianism of the Jain, which often defines his ascetic attitudes to everything that a good Jain does in business. The forbearance that the religion demands from its subjects, differentiates them from most others, contributing to their general success in business.
In the same way, a continuous consciousness of irrationality helps you evolve principles and rules, which help you to “think better” as you go through life. If Behavioural Economics claims to teach you “how to think”, then its central contribution is to fill up the holes in your ‘thinking fabric’ with some substance (which, by the way, maybe as imperfect as the holes you are trying to fill up).
Here is a good example. For those who seek purpose in Life, it seems a good Mission Statement should be made up of the answers to the following 5 questions:
- Who am I? (define in terms of skills, interests, passions, learnability)
- What do I do? (focus on those things that you do exceptionally well, the kind of things you can TEACH others). If you don’t have it, develop it.
- Who do you do it for? (the community should be large and viable)
- What do those people need or want? (i.e. are willing to pay for, that is a good test)
- How do they change as a result? (the delivery, or efficacy test)
Notice that only the first two questions are internally focused (on you, the person whose purpose in Life we are seeking to discover), while the remaining 3 questions are externally focused, on the people in your life.
So one would imagine that if you are choosing to answer this, to get at the purpose in your life, you would want to do it very rationally. And to cut a long story short, I decided on my purpose in Life as “Sanjeev Pandiya helps people achieve financial independence so that they can focus on higher goals in life”.
That sounded like a good Mission Statement for me. When one gets into the details, I found myself describing my vocation as one who goes to SMEs/ HNIs, etc to help locate their “idle assets” and harness them to create extra income, which helps them to “make money from money”, thus creating financial independenceHavingng done this reasonably well, I shoulhaveng happy clients and a fat Bank balance, right?
And what do I notice? While I have been focusing on harnessing other people’s idle assets, I have built a significant amount (of idle assets) of my own. Not rational, is it? But you can’t do both at the same time, no? So even if I have a good Mission Statement, I find myself with the same problem that I am solving for others. So how rational is that?!
Kahnemann says economists have theories (of how things work) while psychologists have lists (of phenomena, of how people think and behave). The former has postulates, while the latter has observations. A good Behavioural Economist must have a foot astride both boats and learn to deftly jump from one (boat) to the other.
Psychology and its Impact on Economics
But psychology and its impact on Economics is but only one aspect of Behavioural Economics. There is already Behavioural Biology, observations about human behavior that come from Evolutionary Biology, Anthropology, and clinical Psychology/ Neuroscience. These contribute a list of predispositions (in our thinking processes) and the reasons for them.
And then there is this new subject called Behavioural Investigation, which tries to develop toolkits to achieve specific (influence) goals, that find applications in Marketing, Finance, Relationships, and the like. You can use it for Options Trading, or for seducing your wife (a far higher objective, I would imagine), especially if she doesn’t know her mind. All in all, a lot of happiness is spread by the practicing Behavioural Economist…….like Buddhism/ Jainism, you use the principles to first elevate your thinking and then spread it around.
A new obsession that mainstream Economics has is with Happiness as the objective of life. Considerable work has gone into defining Happiness and developing attitudes to achieve it, even measure it. The subject is not yet as mathematical as Classical Economics and looks and feels more like philosophy than like Science. It has kind of settled the earlier dilemma that Economics has gone through: is it a science or is it an art/ philosophy? The heyday of Classical Economics (1960-1990) saw a headlong rush towards proving that Economics is a ‘science’ (they still give B.Sc/MS degrees in Economics at some colleges)……that ended badly, with its normative mathematical models failing repeatedly, earning it thnicknameet of a ‘pseudo-science’, with a hit rate only slightly better than astrology.
Improvements started slowly, as Behavioural Economics started to gain a foothold, the first of the Nobel Prizes going to John Nash (1994), who gave a framework for matching objectives and choices, and pointed out that what is visible to the observer is not what is going on in the mind of the (economic) participant. One of them is not strictly ‘rational’. This helped people build structured models to ‘optimize’ scarce resources in a range of applications, helping to increase ‘rationality’ in otherwise flawed decision-making processes. The optimal point was the “Nash Equilibrium”, a mathematically measurable point that obeys certain rules of human behavior.
Today, almost all the incremental progress in economics comes from Behavioural Economics, with mathematical economists relegated to the background. If you look at the work that is getting Nobel Prizes, that is. However, academics continue to be dominated by traditional economics, although research is now veering away. The shift from ‘maximizing (measurable) utility’
to ‘maximizing happiness’ is part of this journey
to ‘maximizing happiness’ is part of this journey. As the objective becomes diffuse and immeasurable, so also must the prescriptions. Today, Economics is now closer to religion than to science.
Kahneman talks of certain weights that we attach to our ‘buying hierarchy’ of decision-making models, wherein we prefer (disproportionately) profits to losses, relative wealth to absolute wealth, present income to future, and low probability-high payoff to high probability-low payoff. Like we buy lotteries, ignoring the low probability of the high payoff. We focus on the information available, rather than the information needed (a big source of losses in the stock market). These biases are the source of much irrationality in our decision-making. Correcting for such biases (after first being conscious of them) will not, however, make our decisions perfect, but will make them better over the longer term.
So back to it being more of a religion, that drives some (although not all) of our behavior, a filter that corrects many of the biases, some inherent and some acquired, that pepper our thinking. And once you have covered the holes in your Swiss cheese, you go after the weaknesses in other people’s (cheese) holes. Over time, your behavior gets differentiated in many ways, giving you a superior life, whether measured in terms of money, happiness any other objective that you define for yourself.